The Truth about Penalties and Forgiveness

The IRS has many tools in their toolbox to promote tax compliance.  One such tool is the penalty.  Penalties can be assessed for non-filing, for accuracy related errors, or for not paying the tax. 

Consider my client Mr. and Mrs. Flipper.  The Flippers formed a partnership outside of their marriage. They failed to file the required tax returns for two years.  The IRS needed the returns filed.  These returns are mandatory.  So the IRS assessed penalties against the partnership.  When the Flippers came to me, the totals were in excess of $10,000 for two years of non-filing.  The partnership didn’t make any money, but that was irrelevant to the IRS.  We were able to get the IRS to abate or forgive the penalties. 

When a taxpayer fails to file and/or pay a tax bill, penalties and interest are piled on, much like carrying a balance forward on a credit card.  The interest and penalties are computed as a percentage of taxes owed.  Interestingly there is no latitude when it comes to interest.  The Internal Revenue Code requires interest to be added.  Penalties, however, are discretionary and can be abated.

Since the interest and penalties are computed as part of the underlying balance, changing that underlying balance will change the interest as well.  For example, I have a client that failed to file a return for several years.  The IRS had reports of income, so they filed a Substitute for Return for my client and sent him a bill of over $100,000 for taxes, penalties and interest.  That is when he came to me.  We filed returns showing expenses that offset most of the income and reduced the amount owed to about $20,000. 

The $80,000 savings came from all three areas.  The base tax was reduced.  Once that was reduced, so were the penalties and interest.  The IRS had to back out the original bill and precompute the bill with a new basis, corrected interest and penalties.  Penalty abatement was not a possibility because of the taxpayer’s history.

If a taxpayer receives a bill for penalties and interest and wants to ask for abatement, the process is straightforward.  If the first-year penalties have been assessed, a first-time abatement is often possible. Partnerships have special dispensation for the second year.  Other than that, penalties need to be abated for cause.  This requires an explanation of the extraordinary circumstances that caused the penalty to be assessed.  If interest has been assessed on previous penalties that have had interest piled on, that interest will be reduced.

The bottom line is to reach out to a tax professional who can perform a detailed analysis of the situation and discuss options.  When communication comes from the IRS or the State DOR, that is the time to reach out.  This is not a time for procrastination.  Putting it off will only make the situation worse.